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Tuesday, November 8, 2011

The ink on the most recent European Union summit agreement was hardly dry before it became clear that it was insufficient. With investors now increasingly wary of Italy, the consensus is growing that the European Central Bank -- and the IMF -- will have to play an even greater role. But will it be enough? By SPIEGEL Staff

When government heads from Germany and the US get together, protocol usually calls for as much pomp as possible: honor guards, hymns, flag parades and the like.

But the tone was decidedly more businesslike at the G-20 summit in Cannes last Thursday. German Chancellor Angela Merkel and US President Barack Obama, together with US Treasury Secretary Timothy Geithner and German Finance Minister Wolfgang Schäuble, met in a mundane conference room at the five-star Intercontinental Carlton Hotel. The group had serious issues to discuss.

Merkel reported on the results of a meeting held a day earlier -- during which she and French President Nicolas Sarkozy had told Greek Prime Minister Georgios Papandreou exactly what they thought about his (now cancelled) plans to hold a national referendum on the euro bailout package. Obama and Geithner, however, were not impressed. The euro crisis continues to worsen, the pair grumbled. It is time, they said, for Europe to finally take decisive action. The decisions taken at the European Union summit in late October were not enough, they complained.

In response, Merkel and Schäuble recited the long list of measures the Europeans had recently initiated. But in reality, they had little to offer in reply to Washington's analysis. The euro crisis, Obama warned, now threatens the global economy.

Too little, too late. That has been the global public's assessment of European efforts to rescue its currency -- for the last one and a half years. And there is every indication that it will remain that way, even after the most recent G-20 meeting. Indeed, concurrent to the meeting in Cannes, the euro zone experienced what was likely the most ridiculous week of events since the crisis began: a Greek referendum announced on Monday, a reversal on Thursday, a national unity coalition promised in Athens on Friday and Papandreou's resignation on Sunday. Things changed almost by the hour, it seemed. And there is still little reason for optimism.

Half-Hearted and Half-Baked

Greece will keep the euro for the time being -- that much is certain. But it also seems clear that this is neither a guarantee of economic health in Greece nor a secure future for the common currency. On the contrary, there were growing doubts on financial markets last week as to whether the resolutions reached at the late-October European summit would be sufficient.

At that meeting, European leaders leveraged their bailout fund to more than a trillion euros. But what was celebrated a week ago as a "tour de force" and a "breakthrough" is now viewed as half-hearted and half-baked. Hardly a politician or economic expert believes that Greece can be rehabilitated under the more current plan from Brussels. And now there are also growing concerns about Italy. Interest rates for Italian treasury bonds reached a new record high last week, and the managers of the European Financial Stability Facility (EFSF) were unwilling to risk tapping the global financial markets. The planned issue of a new EFSF bond was cancelled at the last minute.

Not surprisingly, the mood was grim among the leaders gathered on the French Riviera last week for the G-20 summit. The conclusion, after countless discussions about the crisis, was that much more radical measures are needed. The International Monetary Fund (IMF) and the European Central Bank (ECB) are to take over the management of the debt crisis in the future, and Germany's currency reserves are no longer off limits. Last week Germany's central bank, the Bundesbank, narrowly managed to prevent portions of those reserves from being used to fill the IMF coffers.

Can the "big bazooka" that US politicians, in particular, like to invoke actually save the euro? Many economists are skeptical, because it is primarily economic imbalances that are creating ever-widening rifts between countries in the European currency area. The economic divide between the north, with its strong export economies, and the south, with its high consumption, has grown even further. At the same time, citizens are losing confidence in Europe's ability to manage the crisis.

'Run For Your Lives'

"Run for your lives" is the new motto in Europe, and not just among banks and insurance companies, which are selling off southern European bonds as quickly as they can, but also among ordinary holders of savings accounts. Banks and regulatory agencies are noticing that anxious citizens throughout Europe are trying to bring their money to safety. The flight of capital from Italy, Spain and Greece is in full swing.

Since the beginning of the crisis, ordinary Greeks have withdrawn about €50 billion ($69 billion) from their accounts, or a fifth of total deposits. In May, when the first rumors about a possible withdrawal from the euro zone were making the rounds, the Greeks withdrew €1.5 billion from their accounts within 48 hours. And it is no longer just the rich who are moving their money to a safe place. A Greek nun recently closed her convent's bank account, telling the bank employee that she needed the €700,000 in the account for renovations. But when pressed by the bank employee, she finally admitted that she was worried about her order's assets.

Switzerland is a popular safe haven. The Greeks have reportedly deposited about €280 billion in Swiss banks. At the airport in Athens, passengers are often caught leaving the country with upwards of €100,000 in cash, well in excess of the €10,000 limit.

This capital flight has triggered a boom in the European real estate market, especially in Berlin and London, where wealthy Greeks are buying second homes. Knight Frank, a real estate firm, estimates that about €290 million from Greece was invested in London in 2010 alone.

Lack of Confidence

The Italians are also getting nervous. Figures compiled by the German Bundesbank and the Banca d'Italia, Italy's central bank, suggest that more than €80 billion in capital was moved out of Italy in August and September by Italians concerned about the growing risk of a government insolvency.

Unfortunately, investors' lack of confidence in southern European economies is only too warranted, as a still unpublished study by the Munich-based Ifo Institute for Economic Research shows. The study's authors examined changes in the prices of domestically produced goods and services in the Mediterranean countries before the crisis began. Their figures reveal how the countries systematically ruined their competitiveness.

According to the study, prices of goods produced in Greece went up by an average of 67 percent between 1995 and 2008, a record increase for the euro zone. The average price of domestically produced goods went up by 56 percent in Spain, 47 percent in Portugal and 41 percent in Italy. By contrast, prices went up in Germany by only 9 percent in the same period.

Wage and social policy was a key reason for the differences. While German workers had to make do with modest collective bargaining results and tough reforms, the Mediterranean countries were spending money hand over fist. As a result, the goods they produce are now much too expensive internationally.

The real reason why the common currency has come under so much pressure lies in these divergences. It also explains why the nighttime decisions reached at the last EU summit in Brussels do not offer a lasting solution for the euro crisis.

Part 2: The Next Domino?

"Do the experts in the foreign currency markets seriously believe that the governments' latest 'comprehensive bailout package' for the euro will last more than a few months?" wonders Kenneth Rogoff, an economist at Harvard University and a leading expert on sovereign debt crises. In fact, says Rogoff, he is surprised at how positively the markets reacted initially to the results of the summit.

Rogoff is sharply critical of the Brussels plan, saying that it "relies on a questionable mix of dubious financial-engineering gimmicks and vague promises of modest Asian funding."

Indeed, there are now growing doubts as to whether the agreement is capable of making the bailout fund more effective and giving the Greeks and all of Europe a new outlook.

For example, European leaders decided to reduce Greece's total debt from the current level of more than 160 percent of economic output to about 120 percent by 2020. It's an ambitious goal, but even if it were attained, the Greeks would not be out of the woods by a long shot. A debt-to-GDP ratio of 120 percent would place them at the level at which the ailing Italians are at the moment.

A much lower ratio is needed if a country hopes to be reasonably efficient. In a study of government borrowing in past centuries Rogoff, together with his colleague Carmen Reinhart, have demonstrated that a debt-to-GDP ratio of 90 percent or more cripples growth and increases the risk of insolvency.

Far Too Small

Just as questionable as the restructuring plan for Greece is the idea of boosting the impact of the bailout fund to the trillion-euro level. The problem is that EFSF members are only willing to come up with a portion of the loans to ailing debtor nations, while large private investors like banks and investment funds, as well as emerging economies with large amounts of surplus capital, like China and Brazil, would contribute the rest. But if the major players in the global financial industry could hardly be convinced to buy the bonds of ailing countries last year, why would they do it today, at a time when risk is even more unpredictable and the credibility of a guarantor nation like France is being called into question?

Even if the EFSF reached the desired dimensions, it would still be far too small to rescue Italy, the country that is now the greatest cause for concern for many in Brussels, Berlin and Paris. Amid growing mistrust, the country was forced to offer yields of more than 6 percent last week just to find buyers for a 10-year bond issue, much higher than Germany has to pay for a similar bond.

The levels meant that yields were back to where they had been in early August, says Andrew Bosomworth, head of the German investment management arm of the world's largest bond trader, PIMCO, and responsible for €138 billon in investor funds. That was when the ECB first began buying up Italian bonds in order to keep the interest rate on those bonds manageable.

Bosomworth also noted that the central bankers were "active in the market every day" last week. According to PIMCO estimates, by Thursday the ECB had bought about €10 billion in government bonds -- most of them Italian, Bosomworth suspects.

Aside from the ECB, there are no longer many buyers of Italian treasury bonds. It is clear that most investors are trying to reduce their inventories -- if they can find someone to take the paper off their hands. It is almost as if buyers were boycotting Italian bonds.

Unwilling and Unable

But Italy will have to place €30 billion worth of bonds in the coming weeks. The country's financing requirements will increase to more than €600 billion within three years. Then the government will have to replace the money it once borrowed at low rates with new, more costly bonds. Each additional percentage point costs the Italian government an additional €20 billion in the medium term.

Italy already spends about 5 percent of its total gross domestic product to pay the interest on its government bonds. If that percentage increases, it will become increasingly difficult for Rome to shoulder its enormous burden of debt. At that point, tough austerity measures will be the only way to keep the government's finances under control.

But that is something that Prime Minister Silvio Berlusconi is either unwilling or unable to do. The government did approve a few measures last week, such as the sale of government-owned real estate. However, the program, dubbed a "mini-plan" by the business newspaper Il Sole 24 Ore, is unlikely to achieve much. And even its implementation is uncertain, since Berlusconi would presumably have trouble cobbling together a parliamentary majority to enact the measures. The coalition government is in chaos, writes the paper.

As long as Italy remains politically unreliable, there will continue to be growing concerns that the third-largest economy in the euro zone could turn into a second Greece. And the leaders of the world's major industrialized nations are also worried, as evidenced by their rough treatment of the Italians at last week's G-20 summit.

On Thursday morning, German Finance Minister Schäuble and his French counterpart François Baroin tried to convince their French colleague Giulio Tremonti to implement additional austerity measures. The group reconvened at noon. This time US Treasury Secretary Geithner joined the meeting, and the trio demanded that Italy agree to allow both its reforms and its national budget to be monitored by the IMF -- the kind of measure normally reserved for developing nations dependent on IMF funding. Tremonti was outraged and rejected the idea.

All the More Critical

Nevertheless, the French and the Germans stood their ground. They are, after all, suspicious of the European Commission's monitoring role. They suspect that Commission President José Manuel Barroso is willing to bend the rules a little when it comes to monitoring Italy's fiscal and economic policy, given that his native Portugal is also in economic hot water. Supervision by an independent organization like the IMF, argue France and Germany, is thus all the more critical.

In the evening, Merkel, Sarkozy, Obama and Berlusconi addressed the issue. First they decided that the IMF could issue a new credit line to countries faced with the threat of financing difficulties. It would be issued quickly and without significant conditions to countries with short-term liquidity bottlenecks, like Spain and Italy. The size of the credit line would be based on a given country's share of IMF capital. Spain could expect a maximum of €23 billion in support, while Italy would qualify for €45 billion.

In the end Merkel, Sarkozy and Obama -- a somewhat surprising addition to the German-French euro duo -- prevailed upon Berlusconi to agree to announce further austerity measures. After hours of wavering, Berlusconi finally came around. Nevertheless, there is still much skepticism, and not just among the leaders gathered in Cannes -- over the value of such pronouncements given the country's deep political crisis.

Part 3: Printing Money with the IMF

Obama, at any rate, felt that they would have little value. Instead, he confronted the Germans in Cannes with a suggestion so radical that it alarmed both Merkel and Schäuble. To save the common currency, Obama proposed that the Europeans follow the example of the American Federal Reserve, which buys up almost unlimited amounts of US treasury bonds when necessary.

The Germans pointed out feebly that the ECB operates within a completely different tradition than the Fed, and that it also pursues a different mission. But it is becoming increasingly clear to Merkel and her finance minister that, in the end, only the ECB will be able to save the euro if the crisis continues to escalate. It is the only European fiscal policy institution capable of taking action, and it also comes equipped with unlimited firepower. It can never run out of money, because it can simply print new money when needed.

This is an approach Germany's representatives in the ECB council have strongly resisted. Former Bundesbank President Axel Weber and former ECB chief economist Jürgen Stark resigned from their posts in the dispute over ECB purchases of Greek and Portuguese bonds. Jens Weidmann, the new Bundesbank president, is likewise strictly opposed to funding government deficits by printing money. This position is understandable, given that the Germans have, twice in the last century, seen how this sort of monetary policy can end in hyperinflation and national bankruptcy. But how long can the Germans resist the pressure from other members?

Most European leaders have nothing against using the central bank's reserves as a source of financing, as became evident at the Cannes summit. Important politicians like European Council President Herman Van Rompuy and French President Sarkozy proposed making IMF "special drawing rights" available -- a move which would enable the funding of major bailout packages in Europe. The US also supported the idea.

Another Open Flank

But Bundesbank President Weidmann was deeply troubled and made his concerns known to the chancellor. Special drawing rights, he argued, as well as gold and foreign currency, are part of the currency reserves that the Bundesbank is required by law to safeguard. The Bundesbank fears that issuing the special drawing rights would open yet another door to monetary state-financing. Special drawing rights, the bank notes, are akin to an artificial currency against which foreign currencies can be borrowed at the IMF. Making them available, Germany worries, would be tantamount to opening up yet another flank to the crisis.

Following Weidmann's intervention, Merkel informed her counterparts that the autonomous Bundesbank would not participate in the release the special drawing rights. A battle had been won but not the war itself, as officials at the Bundesbank fear. At the Cannes summit, Van Rompuy spoke of a "trust" at the IMF that could be fed with artificial money from the special drawing rights.

It appears that the euro crisis is approaching its endgame. Many promises made when the common currency was introduced have already been broken. The initial stipulation that only stable countries be allowed in, for example, quickly proved illusory once Italy and Greece were accepted.

Unlimited Fund

German taxpayers were also promised that they would never be held liable for the debts of other countries in the euro zone. But then came the first and second bailout packages for Greece and the European bailout fund.

And now another breach of confidence is on the horizon, with the Germans being expected to accept the notion that the ECB will be available to ailing euro countries as an almost unlimited reserve fund.

The question the German government now faces is whether to preserve the monetary union or have a stable currency. The decision can no longer be put off for long. "To stabilize the situation," says former US Treasury Secretary Lawrence Summers, the bailout measures would have "to go well beyond the measures proposed to date."

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